July 2009

07/24/2009

One challenge system developers face is finding the magic set of rules that will perform reasonably well in a range of market conditions. It can be easy to fixate on optimistic report statistics while losing track of trends in the overall market that may have contributed to the numbers. As the markets are fluid and dynamic, with uptrends and downtrends, our trading systems should be able to handle all that the markets can throw at them.

The overall downtrend in the markets over the past couple of years can create a short-side bias for trading systems - especially trend-following systems. Imagine if your system only went short - you would have probably done pretty well! However, chances are your system would not have done very well if it had been designed to just go long. It is important to find a balance that allows a system to perform well under both bear and bull market phases.

When we design systems, we have the advantage of being able to apply logic to the past x number of years and see how the system would have done: wow, hindsight looks great!

But, even with the past data, it is important to weight the immediate and futures markets as well, even if it's just a guess. We can't assume the markets will continue to go down, just like we can't assume the markets would go up forever. We can assume the markets will move, so having a balanced system deserves some thought.

Take a simple stop-and-reverse 17-day breakout system: if the current day closes higher than the previous 17 days, the system goes long; if the current day closes lower than the previous 17 days, the system reverses and goes short. Figure 1 shows the trades this system took with a definite bias towards the short positions. Look at the performance report in Figure 2. Had we tried this as a long-only system we would have closed up shop. But the shorts kept us afloat. But can we sit back and relax? Probably not. Our short trades are winning much more frequently than our long trades, so I would be worried about how the system would be affected by a change in the market trend.

This is just a thought...

Consider trying to achieve a balance in your trend-following systems so that they can reap the rewards in both bear and bull markets.

Lee Leibfarth is an independent futures trader who designs, tests and implements his own trading systems. He is an affiliate of the Market Technicians Association, and founder of PowerZone Trading. His articles on trading have been featured in The Technical Analysis of Stocks & Commodities, Futures, Active Trader, and Trader’s Journal magazines.

Jean Folger is a stock and futures trader who began her trading business while searching for dynamic portfolio diversification. She discovered day trading and has become highly adept at analyzing and trading the intraday markets. Her articles have been featured in Futures magazine. Jean specializes in teaching and mentoring for women. Their book is available here.

Excerpt from Chapter 7: Developing a Trading Plan

Leverage and Margin

Deciding precisely how much to trade is a key aspect of a trading business that allows traders to control risk and maximize profits. The amount of margin, or leverage, that a trader chooses to use determines how much he or she can buy or sell at any given time. Traders must decide how to use this powerful tool most effectively without creating a high probability of ruin for their trading businesses.

It is recommended that traders begin trading only with a small percentage of the amount of money that is available in their accounts. Traders should start small and increase their position sizes as their profits and trading skills grow. Newer traders that are too anxious to trade larger positions (using the entire value of their accounts and/or large amounts of leverage) almost always fail. Margin and leveraging should be applied with extreme caution.

A trader can determine, for example, the maximum number of shares of QQQQs (trading at $44.20 per share) they could afford to buy with a $60,000 trading account, by dividing the account size by the current value of the stock.

A standard overnight margin account allows 2:1 leverage for stocks, and would give this trader the buying power to purchase twice as many shares than the account size could otherwise afford. This brings the maximum marginable position size up to 2,714 shares (Max Position Size * Margin Rate). It is advised that traders should never trade at maximum margin levels.

A more responsible method to determine a position size is to trade a percentage of the overall marginable value of an account, instead of the complete account value. For example, a trader may choose to base the position size on 30% of the margin account value:

This amount is typically rounded down to the nearest 100 shares to allow for easier order entry and trade management. Accordingly, the above example would relate to 800 shares of the QQQQs.

It should be noted that the futures and forex markets require a necessary amount of margin and this should be factored into any type of position sizing. For instance, trading 30% of a maximum position in the E-mini Russell 2000 futures contract (initial margin of $3,500 per contract) with a $60,000 futures account could be calculated as follows:

As stated above, deciding how to establish a position size is a critical factor in building a trading plan. Two methods are commonly used by traders: constant position sizing and fixed percentage position sizing. Constant position sizing uses the same amount of shares, contracts or currency in every trade, while fixed percentage position sizing varies the position size as the value of the account changes.

A comparison of these two position sizing methods can be seen in Figure 7.2. The equity curve for each of these position sizing models is displayed using a sample trading plan applied to 6 years of historical data from the E-mini Russell 2000 futures contract. An initial account balance of $60,000 was used to construct these equity curves. While the constant position size model would have traded with a consistent five contracts, the fixed percentage model began with five contracts and increased the position size as the account grew. This progressive method of fixed percentage position sizing is one of the key concepts contributing to the effectiveness of the Turtles’ trading plan. This essentially allows traders to compound their trading profits and risk more only after they have made more. The previous equations for max% position size can be used to calculate a position size based on the current account value, and should be calculated following every trade.

While fixed percentage position sizing clearly has the advantage, constant position sizing is still useful to traders. This method can work well for traders who are just getting started, or trading smaller accounts. Constant position sizing should also be used during the testing and evaluation of a trading plan.